I have posted here from Scott Grannis previously because of the regard in which I hold him, but because of the following piece which deeply challenges many of our core assumptions held around here I have decided to open this thread.

As I understand it, The NY Fed in engages in MBS and Operation Twist buys, and purchases the bonds from the Primary Dealers. The money to buy comes from Bank Reserves. Since the Banks do not take out the money, the Reserves can still be lent at 10% fractional banking, even though the Fed is using the money for the Purchases.The "commissions" from the transactions are credited back to the Primary Dealers as more Reserves.

Reserves held are somewhere about $1 trillion. In the last 6 months alone, the Fed has purchased $85b per month, which would amount to about $500b total. Over the last couple of years, the Fed has bought over $1T in MBS.

Please explain to me how the Fed can keep buying using Reserve money. That money has to exhaust itself at some point, even with the new "commissions" being credited to the Reserves.

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Scott replies:

The Fed can buy anything it wants (so far only Treasuries and MBS), but it can only pay for what it buys by crediting a bank's reserve account with "reserves." Bank reserves are "money" that only exists at the Fed. You can't spend reserves on anything. Reserves are only good for 2 things: 1) banks are required to hold about $1 of reserves for every $10 of deposits, and 2) banks can exchange their reserves for currency.

In the past, prior to 2008, banks wanted to minimize their holdings of reserves because reserves did not pay any interest. Banks would actively sell excess reserves on the overnight market to other banks that needed them to meet their reserve requirements. If the banking system wanted to increase its lending, then banks in aggregate would need to increase their holdings of reserves because increased lending means increased deposits: banks "create" money by extending loans to people, and that is done by crediting the borrower with a deposit. The Fed actively managed the supply of reserves to the banking system in order to control the amount of money that banks were able to create.

Since 2008 lots of things have changed, most important being the fact that the Fed now pays interest on reserves. Reserves have now become the functional equivalent of T-bills. In fact, they are more attractive that T-bills, because 3-mo. T-bills only pay 0.06% interest, while reserves pay 0.25%.

Banks have been very willing to accumulate reserves in their Fed accounts, because reserves are the most attractive way to own safe assets. Banks have been forced to increase their capital requirements and clean up their balance sheets, and holding more reserves is the most efficient way to do that.

So what the Fed has been doing is transmuting T-bonds and MBS into very attractive "safe" assets that the world has been very hungry for. With risk-aversion still very high all over the world, the Fed has been working hard to create safe assets in sufficient quantity to satisfy the world's voracious demand for safe assets.

Banks have increased their lending activity only very modestly, despite their huge accumulation of reserves. This is "proof" that the Fed has only been supplying safe assets to the banking system in response to banks' demand for safe assets. If banks didn't want to hold so many reserves, they would be inundating the world with new loans and the money supply would be increasing at a tremendous rate. But that's not happening. There is no sign of a huge excess supply of money. Gold has gone nowhere for almost 2 years. Commodity prices have gone nowhere for the past 5 years. The dollar is up against most currencies over the past 5 years. Inflation has been about 2.5% per year for the past 5 years.

Here is a chart of bank reserves, which have grown by $1.75 trillion since late 2008:

Of the current total of $1.87 trillion of reserves, only $0.116 trillion are "required" to back up bank deposits. So there is a total of $1.75 trillion of "excess" reserves that banks are holding because they want to hold them.

Currency in circulation has increased by about $315 billion since late 2008, which means that banks have exchanged an equal amount of reserves for currency. Since the amount of currency in circulation is never more than the demand for currency (unwanted currency can simply be returned to the Fed in exchange for reserves which pay interest), the 7% annualized growth of currency is a measure of how hungry the world has been for dollar cash (the bulk of dollar currency in circulation is held overseas).

Altogether, the Fed has purchased a little over $2 trillion of bonds and MBS since September 2008; $315 billion of that now exists in the form of currency in circulation, and the rest is sitting in banks' reserve accounts at the Fed where it earns interest.

The Fed has monetized federal government debt only to the extent that the world has preferred to increase its holdings of safe dollar assets and dollar currency. This is not scary, nor the end of the world.

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a response:

<This is "proof" that the Fed has only been supplying safe assets to the banking system in response to banks' demand for safe assets.>

I find this statement absolutely incredible. Sure the banks have a "demand" for "safe assets" -- they want to get all those toxic assets off their balance sheet and replace them with something that has a known value. Very logical. But what is happening is that the banks have been badly managed and are loaded with assets that either can't be priced at all, or have a market value substantially lower than the price the bank paid. Why should the Fed bail out these bad investment decisions? The cost will surely fall on all the rest of us in time, if not immediately.

If a person or a bank wants to change its assets for different assets, let that person or bank sell its assets on the open market and then buy what it wants. Why should bankers get a free ride that is unavailable to anybody else?

Free markets yield asset and goods prices which are beneficial in countless ways. The central planners in the Fed are not helping to promote a growth economy. In the financial realm we might as well be living with the Politburo.===============================, , ,

Scott, your reference to 2.5% annual inflation really baffles me. I'm sure that is the official number but I really question it based on my personal experience. Add 5% and I think it's in the ballpark, maybe still a little low. As Pat pointed out, the things I buy are rising at a much greater rate than 2.5% per year. I put this figure in the same basket as purported "budget cuts" which are really reductions in projected growth. Truth seems badly lacking in Washington and I don't believe the 2.5% figure. If prices were increasing in the high single digits how would that change your view of things?

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I have been a student of monetary policy and inflation for more than 30 years. It started when I lived in Argentina in the late 1970s, at a time when inflation was routinely in the triple digits.

I have spent the better part of three decades sifting through the economic statistics of the U.S. and many other countries. I am as skeptical as anyone when it comes to government stats. But I am convinced that the U.S. (and almost all other countries) are doing a pretty good job of measuring inflation and other macro economic statistics. The simple truth is that all these numbers are so interrelated that you can't just fudge one, you have to fudge everything. There are many measures of inflation and growth, and they are all consistent with each other.

I know very well that lots of prices at the store are up, and up big time. But I think it's easy to forget all the prices that are falling. Inflation is measured by averaging the prices of everything. So maybe cereal is going up, but computers are going way down.

The only country that is fudging its inflation numbers these days is Argentina. Believe me, it is very obvious just by looking at the numbers. The government says inflation is only about 10%, but it is really more like 30%. =================

, , ,

Scott replies:

The CPI is the most basic, and most narrow measure of inflation. There are others that are much better, since they measure a much broader range of prices, and they correct for changing quantities: the Personal Consumption Deflator and the GDP implicit price deflator. All measures say pretty much the same thing: inflation is somewhere in the range of 2-3% a year. But that masks a huge and ongoing change in relative prices of different types of goods and services.

Durable goods prices, on average, and taking into account qualitative improvements, have declined almost 30% in the past 18 years. This has never happened before, and it is highly significant, easy to overlook, and easy to underestimate:

The consensus among the people I am dealing with is that if QE stops buying MBS, goodbye to Real Estate. MBS buys account for 50% of the GSE business.===========================

Scott responds:

I seriously doubt whether the end of QE would spell disaster. The Fed currently owns only a fraction (about 12-15%) of marketable Treasuries and only a fraction of outstanding MBS. Their purchases can not seriously distort or impact these markets. What most people fail to understand is that Treasuries and MBS are bonds, and bonds are largely fungible. A 7-year bond is almost identical to an 8-year bond, and MBS and Treasuries share some characteristics and can even be made to look like each other with the use of derivatives. What sets the price of bonds is the prevailing level of interest rates, that that level in turn is set by macroeconomic forces that operate on all bonds. The Fed's purchases are a drop in the bucket; the global bond market is several tens of trillions in size, and the Fed only owns only $1.8 trillion of Treasuries and $1 trillion of MBS.

Also, bear in mind that the Fed is not going to stop QE unless and until they judge the economy to be fundamentally stronger. A stronger economy naturally warrants higher interest rates. Higher mortgage rates will not necessarily wipe out the housing market if the economy is improving.

Interest rates today are low because the economy is perceived to be very weak. A stronger economy tomorrow will justify higher interest rates. The economy drives interest rates, not the other way around.

Quantitative expansion: We are pouring kerosene all around, giving it no spark, and then pointing out no observed increase in fire or heat - so far.

Scott and I have reversed positions on the inflation concern, if my memory is correct. Without finding the exact exchange, I argued a few years ago that the Fed's record against inflation was not too bad, typically 2-3% per year and it was pointed out back to me what a huge loss of value that is over any extended time period, which is true.

Now Scott argues: "The idea that the Fed is "printing money" with abandon, and that this is seriously debasing the U.S. dollar, is a fiction borne of ignorance of how monetary policy actually works."

I find his hedging, second sentence far more telling: "Fed policy may indeed pose the risk of serious debasement in the future..." - Unfortunately, Yes.

My view is that inflation is the diluting of our currency and that general price level increases are a consequence of that, following in time and dependent on other variables as well.

What did Milton Friedman say: MV = PQ

(From a previous post: http://dogbrothers.com/phpBB2/index.php?topic=985.msg70088#msg70088)These four very important but difficult to measure variables are all intrinsically tied to each other, either proportionally or inversely. The money supply times the velocity of money (MV) equals the total value of all the goods and services (PQ) in the economy.

We know the Fed is 'monetizing' at the rate of 3/4 of trillion dollars a year (M). We are pouring in the dollars, literally in the trillions, and by measuring the result indirectly we are saying it isn't increasing the money supply any faster than usual.

We know velocity (V) as measured is way down, and I would argue is a poorly measured phenomenon currently understating the malaise.

We know Price levels (P) are all over the map, some up, some down, with a net result so far allegedly only at 2-3% price increases per year.

We know that the total amount of goods and services in the economy (Q), is virtually flat in our no-growth economy.

IF and when economic growth and vitality returns, then what? Rejuvenated velocity will multiply with the trillions of accumulated monetary expansion (do we know how to put that toothpaste back in the tube?) and drive price levels to spiral up faster than actual output can or will increase. MHO.

I admit 'ignorance of how monetary policy actually works'. I wish our dual mission Fed had the same humility. My trust of the Fed knowing what they are doing would be much greater if they weren't working on the dual mission of pretending to help with unemployment, not a monetary problem, while working to maintain a stable value of our currency.

The questioning of Scott's analysis continues:==========================================================Scott,

You keep looking at this from a one dimensional perspective. It is not that simple.

The only thing keeping housing where it is right now is because the Fed is purchasing 50% of all new mortgage originations. That is because there is little demand for the new GSE MBS's, since the return on the new MBS's are running no more than 2.75%. Who in their right mind would buy an MBS for a 30 year period of time, with a return of 2.75%? This is negative income, even now.

There is no one ready to pick up the slack if the Fed jumps out of the market. There are too many things to be done to rebuild the foundation for lending to begin again.

1. Fannie and Freddie are being wound done. In fact, as of today, the Fannie Portfolio is 30% less than what it was at the peak. In five years, both Fannie and Freddie are to be completely wound down, but there has been no decision by the government on what to replace them with, or even replace them at all. (My people think that the government will likely create similar entities, only smaller, which will simple be GSE 2.)

2. The banks can't portfolio lend for several reasons. a) Basel 3 requirements for reserves are so complicated that no one can determine how mortgage loans are going to be tiered. b) CFPB rule making for loans is going slower than anticipated, and the banks are afraid to lend otherwise. 3) A serious lack of qualified borrowers based upon current underwriting methods. d) There is no way that current default risk can be properly evaluated. Deefault Risk is the key to complying with Basel 3. e) Follow up systems developed to continuously monitor and adjust for risk as economic and other issues change, so that Basel 3 can be complied with after loan originations. f) Home values are still uncertain, and so lending practices must consider that, and factor that into future risk evaluations as well. This must all be resolved for portfolio lending to resume.

3. Dodd Frank compliance with the lender Fiduciary Duty to a Borrower and Ability to Pay issues. This is a key point. The Qualified Mortgage is supposed to take care of this issue, through a Safe Harbor that will protect lenders from lawsuits on a Qualified Mortgage and Ability to Pay issues, but I have already figured out how to attack that, so we are trying to create processes to ensure that lenders will have a viable defense in the event of lawsuits. Who will lend on loans where they would be subject to lawsuits?

4. Private Securitization is still essentially non-existent. Only a few companies are doing Private MBS, and with such high quality of loans, few loans could even qualify. Private Securitization cannot be restarted until underwriting issues and Ability to Pay issues are resolved, since those loans will generally not be subject to the Safe Harbor provision. Additionally, as we found out, the algorithms that were used to defer risk in the Trusts were faulty. New methods of populating the Trusts must be done to adequately defer risk. To do that, Default Risk must be properly evaluated on each loan, so that the risk can be spread out.

5. Hard Money lenders will cease to exist in almost all forms. Dodd Frank and the CFPB will drive them out, beginning next year. This is a whole category of lending that has not even begun to be addressed, yet borrowers often do have a need for Hard Money, under certain situations.

6. Banks cannot loosen lending standards on a whim. Just reducing FICO scores or allowing smaller down payments don't work. FHA has shown that to be a problem. There is much to be considered with any loan, including Cash Flow Analysis for an individual borrower. We are working on that as well.

7. Stress tests for banks are very critical. The tests involve multi-faceted scenarios, across all lending platforms, and under varying economic and political conditions. We have people who have developed such tests in the past and are currently improving upon them for the future.

These are only a few of the issues that directly affect the housing market, and don't even begin to go into the continuing default servicing, modifications issues, negative equity, population demographics and other issues that will come into play as well.

That is why:

1. The Fed cannot discontinue QE until these issues are worked out.

2. If they do discontinue QE before the issues are resolved, housing will crash again, and much harder.

I have sidebarred Scott and asked for his comments about our conversations here and he has been kind enough to oblige:================================

Yes, you are (mostly) all at variance with how I see things. To me it is very clear, whereas I think you guys are not viewing things from the proper perspective. The economy is in bad shape, but it IS improving. The deficit IS declining. Government spending as % of GDP IS declining. The deficit IS shrinking.

Yes, things are very bad. This is the worst recovery ever. Obama is a disaster. Obamacare is a huge disaster. Employment is way below where it should be. Congress doesn't seem to understand anything. Fiscal policy is all wrong: instead of increasing spending and increasing tax rates, we should be reducing spending and reducing tax rates. I could go on.

But all of this is known. This is old news. This is why PE ratios are still below average even though corporate profits are at all-time record highs, both nominally and relative to GDP. This is why the dollar is very near its all-time lows. This is why the demand for money is extraordinarily high.

So: what is important is what is happening on the margin. On the margin, government spending is not increasing. Government spending is decreasing relative to GPD. Congress is gridlocked. Taxes are not going to rise, and the Republicans are going to pick up seats next year and it will be even harder for taxes and spending to rise. It's far from certain that Obama will be able to push through his budget; his popularity is falling and he is not engaged. Dems who are facing re-election next year are already sh*tting in their pants. The deficit is declining, both nominally and relative to GDP, and by a LOT. If current trends continue, the deficit will be zero within 8 years or so.

Obamacare is so bad that it is far from certain that it will see the light of day without suffering huge changes or postponements. Lots of things can happen between now and the end of the year to modify Obamacare. The private sector is already hard at work searching for alternatives which work. And there are many that are surfacing already. Concierge medicine, instant clinics, etc. It would only take ONE change to the tax code to change everyone's incentives for the better: make healthcare insurance deductible for everyone, not just employers.

The world according to Obama is unsustainable, therefore it will not happen.

Where he loses me starts with this: "the Republicans are going to pick up seats next year", and to presume Republicans or at least responsible economic and fiscal views will do reasonably well thereafter.

There is plenty in history to support that prediction, unless one believes there is a major political shift going on.

If you substitute 50-50 in place of that certainty, the outlook is quite a bit scarier.

While the trillion dollar deficits are narrowing, that permanent debt accumulated all that time and continues to grow, as do the unfunded liabilities. Also accumulating is the number of people who permanently left work and the number of years since this economy has generated healthy start-up businesses, hungry to grow output and employment.

What is different with this catastrophe as opposed to say WWII or 9/11 is that we deliberately chose this train wreck and for the most part just voted again to keep it going. If not for the political art of re-districting (Republicans lost the House election nationally by 1%), the forces of stagnation and decline would already control all branches of government.

Everything you think you know about the Fed is wrongby Mark Dow and Michael Sedacca

Few would still argue against the assertion that the Federal Reserve has been central to the financial stabilization and economic recovery from the 2008 crisis. They fixed the plumbing and are now trying to incentivize animal spirits to pump water through the pipes. The debate has now migrated to exit strategies and whether growing side effects from exceptional monetary accommodation outweigh incremental benefits.

Nonetheless, it is the Fed, views are heated, and many misperceptions persist. The concept of money printing resonates strongly and intuitively with almost everyone, but most of the intuitive reactions to the Fed’s QE are turning out to have been wrong. Here are some of the major ones that linger.

1. Money printing increases the money supply. The Fed does notcontrol the money supply; they control base money (or inside money), which is a small fraction of the broader money supply. In our fractional reserve system, the banks (loosely defined) control the other 90% or so of the money supply (a.k.a. outside money). And the banks have not been lending. This is why the money supply has not grown rapidly in response to years now of QE.

2. QE is “pumping cash into the stock market”. The truth is little of this money finds its way into the stock market. When the Fed implements QE, they are buying low-risk US Treasuries and agency mortgages from the market, mostly from banks. About 82% of the money the Fed has injected since QE started has been re-deposited with the Fed as excess reserves. With the remaining 18%, banks have tended to buy other fixed income assets of a slightly riskier nature—moving out the risk spectrum for a bank doesn’t mean jumping into equities, especially given the near-death experience that most of them have just gone through.

Of course, not all of the USTs and MBS were purchased from banks. And some of the money does end up in equities. But, really, not all that much. The other big holders of USTs/MSBs who’ve been selling to the Fed for the most part have fixed-income mandates too, and they are also unlikely to take the cash from the Fed and cross over into equities with it.

So, the natural question is why—if the above is true—have equities gone up so much in response to QE? The simple answer? Psychology and misconception.By taking an aggressive stand, the Fed signaled to markets that “I’ve got this”. The confidence that the Fed would do everything it could to protect our economic downside stabilized animal spirits. Then it slowly but surely enabled risk taking to re-engage. The fact that so many people believe that the Fed would be “pumping money into the stock market” and so many buy into the aphorism “don’t fight the Fed” (notwithstanding September 2007 to March 2009) made the effect that much more powerful.

In short, this largely psychological effect on markets—one that I (Mark) had initially underestimated—bought time for household balance sheets to heal and is allowing fundamentals to catch up somewhat with market prices.

3. QE will create runaway inflation. “Yet” has become the favorite word of the inflationistas. As in, “Oh, it’ll come, just hasn’t yet”. And the magnitude of that expected inflation has been dialed down from ‘hyperinflation’ to ‘high inflation’.

But some continue to hang on. The most extreme inflationistas insist that it is here now and the Fed is cooking the books. The reality, of course, is the Fed has nothing to do with the compilation of US inflation statistics, which is done by the BLS. Moreover, for those who are worried that all departments of government are conspiring against the American people, you would also have to believe the MIT is in on it too. MIT runs the Billion Price Project, a means of testing, using broad-based internet price sampling techniques, the extent to which the government’s measure of CPI reflects reality.

But, there really has been no inflation, even with rounds of QE and interest rates stuck at zero. What we have learned in this crisis has driven home the points that the lending and borrowing that drive the money supply are more sensitive to risk appetite than they are to the price of money.

Is it possible that this will end in a bout of inflation? Yes. But the odds are lower than consensus had been thinking and they are dropping—fast , as inflation continues to be well anchored and people come to understand better how the transmission mechanism of monetary policy actually works.

4. QE is the reason we have high oil/gasoline prices. This very deeply-held view is just as deeply mistaken. As the chart below shows, post crisis/post QE, oil prices on average (red line) have gyrated around 80-90 dollars per barrel with no ascending trend. The ascending trend came well before we knew what QE even was, in the 2002-2007 period. And the most rapid phase of its rise took place as the Fed was raising rates from 2004-2006.

Paying high prices makes all of us angry, and it feels good to have someone to lash out at, but, alas, reality disagrees.

What, then, caused the rise in the price of oil? In brief, the rise of China after it joined the WTO in 2002 and investor allocations to commodities as a “new asset class”, with trend followers, speculators and prop desks front-running the pack. Remember this was a period in which leverage was building and speculative juices flowing full steam.In any event, it’s pretty clear it was not a result of the Fed and QE.

5. QE has debased the dollar. Good luck convincing people this hasn’t been the case. This is an excellent example of repeating a falsehood until it becomes accepted as true.Again, roll tape…

This is the trade-weighted broad-dollar average. It, much like the oil chart above, shows all the action took place before QE and the crisis. From 2002 to 2007 the Big Dollar, as currency specialists like to call it, depreciated some 20%. And the fastest depreciation came…that’s right, when the Fed was raising policy rates. Since the crisis oil has been roughly unchanged, with gyrations suspiciously similar to oil’s.

Bottom line: Anyone alleging debasement is working from hearsay and priors, not the scorecard. And there are some pretty high-profile people still throwing around the ‘debasement’ word.

In fairness, the Fed did assume that their exceptional monetary accommodation might result in some depreciation of the dollar. But because the US is a closed economy (exports and imports make up a relatively small share of GDP) the Fed felt—correctly in our view—that it should be setting monetary conditions based on the larger domestic economy. And if dollar depreciation were to ensue, so the thinking went, it would at the margin be positive for US growth, as long as the depreciation was orderly.

Why, then, did the dollar depreciate so much in the 2002-2007 period? Pretty much the same reasons as with oil: it was a period of risk-taking, leverage and deepening optimism regarding emerging markets. All three factors led to dollar selling—well before QE ever made its first appearance in the US.

In sum, much of the received wisdom surrounding the Fed and the effects of its actions is misplaced. Through repetition and ex-ante biases deep misunderstandings have become ingrained in market psychology.

Importantly however, the recent rise in the dollar and fall in commodities suggest that these long-held misguided views are becoming dislodged. There is plenty of risk ahead and the Fed’s task is far from easy or over. But the Fed, for the most part, is ahead of the curve. Make sure

<<“The Federal Reserve is printing money”. No statement could be less truthful. The Federal Reserve (Fed) is not, and has not been, “printing money” as defined as an acceleration in M2 or money supply. Just check the facts.>>

OTOH, here is an Austrian response:

Much of this is correct, as far as it goes. But let's look at this statement: "This is why the money supply has not grown rapidly in response to years now of QE".

It's obviously true that the Fed has grown "base money" much faster than it has grown the "money supply." If the "money supply" had grown as rapidly as base money, the consequences would likely have been catastrophic. As this article points out, however, there are several ways in which the Fed's purchases have in fact added to the money supply. The rate of such growth has been slow compared base money growth, but that rate has frequently been between 10% and 15% per annum. To say that is "not rapid" overstates the argument. See Michael Pollaro's work for money growth information. Here is Pollaro's definition of the money supply. Note, however, that Pollaro's data does show that money supply growth rates may now be falling.

Not only does this article understate the amount of monetary inflation, it leaves out the principal problem caused by monetary inflation. The problem is that every bit of new money causes relative price distortions wherever that new money is spent. Relative price distortions cause economic actors to make mistakes, both in their consumption and producing decisions. These mistakes result in malinvestments that must ultimately be rectified by market corrections that we describe as "recessions." A recession can be a relatively mild event, or something more significant if the central planners push the distortions beyond the norm.

The author says:

"Few would still argue against the assertion that the Federal Reserve has been central to the financial stabilization and economic recovery from the 2008 crisis. They fixed the plumbing and are now trying to incentivize animal spirits to pump water through the pipes."

This is absolutely ludicrous, although certainly accepted widely by our mainstream economists and other statists who insist that money must be managed by central planners. Never do these people explain how, exactly, the Federal Reserve has "fixed the plumbing." And they have no clue as to how the "plumbing" got broken in the first place. Never do they explain how the Fed's further actions will "pump water through the pipes."

The Fed has done the only thing it is capable of doing: it has shifted the cost of its bad policies from the banks to the public at large, and it has promoted -- yet again -- enough bubble activities and government spending to produce some rising economic aggregates.

An economy is not a machine. Free market prices are the only method of "incentivizing" people to produce goods and services which actually tend to meet consumer needs. We don't need just any "animal spirits"! We need to have an economy producing goods that people want to buy and can afford to buy out of income generated by producing something useful. Selling things to people by lending them money they can never repay ought to be a discredited idea by now!

Our central planners have done us no favors, to say the least. The Fed has been the most direct cause of all our boom/bust cycles since 1913, and since 2000 the Fed has adopted more and more extreme behaviors that have already produced enormous unintended consequences. The Fed's continued zero interest rate policies can never lead to beneficial improvements in the US economy, or the world economy, for that matter. Fed policies will continue to pile on economic distortions until something happens that makes the housing bust look like an inconvenience -- just as the housing bust made the aborted 2000-2001 recession look like a much better idea

The 'Austrian' already answered the points in the post, but I offer this:

1) "In our fractional reserve system, the banks control the other 90% or so of the money supply." - The Fed controls the 10% and controls the fractions and rules that govern the other 90%. If M1 or M1 plus M2 is the money supply, why do we have M3, M4, etc. and still have no way of accurately measuring money supply in a largely electronic monetary system? The precedent for what we are doing today and where it worked out just fine is WHEN?

2) "The truth is little of this money [QE in the trillions of dollars] finds its way into the stock market." - Absurd IMHO to think this market movement was not largely driven by the monetary expansion. The Fed also set interest rates to zero which effectively shut done the alternatives to investing in equities like fixed rate bonds and savings accounts. Without QE-infinity but with the current anti-investment policies, where would the DOW be? Same? Surely you jest.

3) "there really has been no inflation" - I don't agree that inflation of the currency is equal to the current CPI change. Milton Friedman's theory for example says that Price level in a stagnant output economy is proportional to Money Supply times Velocity, not money supply alone. When Velocity returns, what happens to Price level, or is stagnation permanent?

4) "The ascending trend [QE did not cause high gas prices] came well before we knew what QE even was, in the 2002-2007 period." - A distinction without a difference, QE is one golf club in the bag of easy money. The period 2002-2007 was a period of easy money. Right? The only reasons energy prices aren't even worse: a) demand has been subdued by the depression, and b) production increased in spite of federal government attempts to stop it. If gold is the 'gold standard' of money, isn't it interesting that the oil in gold price is nearly the same today as it was in 1973. Can we say that for Fed management of the dollar?

5) "QE has [not] debased the dollar." - The author ridicules the "yet" argument because he hasn't seen spiraling price increases during any part of this long, pathetic period of stagnation. April 2013, FYI to the author, is not the finish line for measuring the results of this policy.----

Let's ask the question backwards. If not for the "dual mission" of the Fed where they are charged with fighting a non-monetary problem of unemployment with monetary tools only, would the QE-infinity policy, to the scale of multiples of trillions, have been exactly the same? If not, why not?

And what about federal debt explosion? Would the trillion dollar deficits have persisted for FIVE YEARS AND COUNTING if not for the enabling of the Fed? The federal spenders have not had to pay market price for money or face a market reaction or even find willing buyers of bonds in order to 'borrow' and spend. QE enables them to not have to borrow in amounts equal to the over-spending. If not for that enabling in the trillions of dollars, would the deficits have been that large and irresponsible? I highly doubt it. The laws of nature, unimpeded, would have resulted in interest rates that would have made over-borrowing and generational theft at anywhere near these levels prohibitive.

The most important point is that these fools in the Federal Reserve are trying to manage the economy to achieve certain outcomes. It cannot be done. It should not be attempted. They are harming us all and endangering our future.

I will post below an excerpt from a Paul Volcker speech given just this week. Volcker is very much a mainstream economist, of course. A guy who spent much of his career in central banking. Volcker is very polite, but it's also clear that in his opinion our contemporary central bankers don't know what the fcuk they are doing. IMHO, he is understating the case by a very significant margin.

Tom

Via Doug Noland’s Credit Bubble Bulletin:

From “Central Banking at a Crossroad,” Paul Volcker, The Economic Club of New York, May 29, 2013

“In no doubt, the challenge of orderly withdrawal from today’s (vs. 1950s) broader regime of quantitative easing is far more complicated. The still growing size and composition of the Fed’s balance sheet implies the need for, at the least, an extended period of disengagement. Moreover, the extraordinary commitment of Federal Reserve resources alongside other instruments of government intervention is now totally dominating the largest sector of our capital markets – that for residential mortgages. Indeed, I do not believe it an exaggeration to note that the Federal Reserve with assets of $3.5 Trillion and still growing is, in effect, acting as the world’s largest financial intermediator, by acquiring long-term obligations and financing short-terms, of course aided and abetted by the unique privilege to create its own liabilities.

Beneficial effects of the actual and potential monetization of public and private debt – the essence of the various QE programs – appear limited and diminishing over time. The old “pushing on a string” analogy is relevant. And the risks of encouraging speculative distortions and the inflationary potential of the current approach plainly deserve attention. All of this has given rise, obviously, to debate within the Federal Reserve Board itself. In that debate, I trust sight is not lost of the merits - economically and politically - of an ultimate return to more orthodox central banking approaches.

I do not doubt the ability and the understanding of chairman Bernanke and his colleagues. They have a very considerable range of tools and instruments available to them to manage the transition. They include the novel approach of paying interest on excess reserves, potentially sterilizing their monetary impact. What is at issue – what is always at issue – are matters of good judgment, leadership and institutional backbone. The willingness to act with conviction in the face of predictable political opposition and substantive debate is, as always, a requisite part of a central bank’s DNA.

Those are not qualities that can be learned from textbooks. Abstract economic modeling and the endless regressions of econometricians will be of little help. The new approach of “behavioral” economics itself is recognition of the limitations of mathematical approaches, but that new “science” is in its infancy.

I think a reading of history may be more relevant. Here and elsewhere the temptation has been strong to wait and see before acting to remove stimulus and then moving toward restraint. Too often the result is to be too late, to fail to appreciate growing imbalances and inflationary pressures before they are well ingrained.

There is something else beyond the necessary mechanics and the timely action that is at stake: the credibility of the Federal Reserve, its commitment to maintain price stability and its ability to stand up against pressing and partisan political pressures is critical. Independence cannot be just a slogan. Nor does the language of the Federal Reserve Act itself assure protection, as was demonstrated in a period after World War II. Then, as now, the law and its protections seem clear, but then it was the Treasury for a long time that called the tune.

In the last analysis, independence rests on perceptions of high competence, of unquestioned integrity and the will to act. Clear lines of accountability to the Congress and to the public need to be honored. Moreover, maintenance of independence in a democratic society ultimately depends on something beyond those internal institutional qualities. The Federal Reserve – any central bank – should not be asked to do too much – to undertake responsibilities that it cannot responsibly meet with its appropriately limited powers.

I know it’s fashionable to talk about a dual mandate – that policy should somehow be directed to two objectives of price stability and full employment. Fashionable or not, I find that mandate both operationally confusing and ultimately illusionary. Operationally confusing and in breeding incessant debate in the Fed and the markets about which way policy should lead – month to month, quarter to quarter – with close inspection of every passing statistic. More important, illusionary implies a tradeoff between economic growth and price stability – a concept that I thought had been long refuted not just by Nobel prize winners but by experience.

The Federal Reserve, after all, has only one basic instrument so far as economic management is concerned – managing the supply of money and liquidity. Asked to do too much - for instance to accommodate misguided fiscal policies, to deal with structural imbalances, or to square continuously the hypothetical circles of stability, growth and full employment - then it will inevitably fall short. If in the process of trying it loses sight of its basic responsibility for price stability, a matter that is within the range of its influence, then those other goals will be beyond its reach.

Back in the 1950s, after the Federal Reserve finally regained its operational independence, it decided to confine its open market operations almost entirely to the short-term money markets – the so-called “bills only doctrine.” We can’t go back to that – we can’t go home again to the simpler days of the 1950s and 1960s. Markets and institutions are much larger, far more complex. They have also proved to be more fragile, potentially subject to large, destabilizing swings in behavior. The rise of shadow banking, the relative decline of regulated commercial banks, the rapid innovation of new instruments have all challenged both central banks and other regulatory authorities.

But one simple logic remains. It is, I think, reinforced by these developments. The basic responsibility of a central bank is to maintain reasonable price stability - and by extension that means it must take account of the stability of financial markets generally. In my judgment, those functions are complimentary and they should be doable.

With or without a numerical target, the broad responsibility for price stability over time does not in any way imply an inability to conduct ordinary counter-cyclical policies. Indeed, in my judgment confidence in the ability and commitment of the Federal Reserve or any central bank to maintain price stability over time is precisely what makes it possible to act aggressively in supplying liquidity in recession or when the economy is in a prolonged period of growth well below potential.

Credibility is an enormous asset. Once earned, it must not be frittered away by yielding to the notion that a “little inflation right now” is a good thing to release animal spirits and to pep up investment. The implicit assumption behind the siren call must be that the inflation rate can be manipulated to reach economic objectives – up today, maybe a little more tomorrow, and then pulled back on command. But all experience amply demonstrates that inflation, when fairly and deliberately started, is hard to control and reverse. Credibility is lost.

I have long argued that central bank concern for stability must range beyond prices for goods and services to the stability and strength of financial markets and institutions generally. I am afraid we collectively lost sight of the importance of banks and markets robustly able to maintain efficient and orderly functioning in time of stress. Nor has market discipline alone restrained episodes of unsustainable exuberance before the point of crisis. Too often, we were victims of theorizing that markets and institutions could and would take care of themselves.

My concerns in that respect and their relevance to central banking and the organization of regulatory authority, were more fully expressed in a speech to this Club several years ago. Congress was then beginning to consider reform legislation. It was recognized that regulatory agencies, perhaps most specifically the Federal Reserve, had exhibited a certain laxity and ineffectiveness in the period leading up to the financial breakdown, particularly with respect to the mortgage market…

The erosion of confidence and trust in the financial world, in the financial authorities that oversee it, and in government generally is palpable. That can’t be healthy for markets or for the regulatory community. It surely can’t be healthy for the world’s greatest democracy, now challenged in its role of political and economic leadership…

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I share all of these concerns about the Feds ability to exit QE in a timely fashion. So what should an investor do when confronted with this risk? That is arguably a more important question than whether the fed should be reformed.

Suggestions?

Scott Grannis

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Tom,

Obviously, the Fed has far exceeded its mandate in Mortgage Lending. The CFPB, which was established under control of the Fed by Dodd Frank, is setting the new mortgage lending regulations, and risk as well. Coupled with the MBS purchases, the Fed is taking over mortgage lending.

I am going to post a primer on MBS so that all can get a better understanding of how it works. Then, when one realizes that the Fed is buying 93% of all new origination MBS, it really goes to show how the Fed has manipulated rates.

Pat-------------------------------

This comes from Mortgage News Daily, an industry website that covers events as they happen. One thing that they do is to follow MBS pricing daily, throughout the day, showing changes, etc, so that lenders and brokers can react to what is occurring.

The data provided here gives a good primer to the understanding of MBS, price changes, etc. When what is here is applied to Feb operations, it gives better insight to understanding. But, even then, it is only a primer. And as Scott will attest to, this is simplified greatly.

Any time you see us write MBS in this blog, or anywhere else for that matter, we're always going to be referring to Mortgage Backed Securities. These are the securities comprised of groups of similar mortgages, also known as "pools." MBS function similarly to other bonds in that have a purchase PRICE and pay the investor back in installments based on the YIELD. The PRICE always refers to the cost of buying $100 of that particular bond. For instance, if the price of a bond is 101.00, then an investor would pay $101.00, and in exchange, would then own only $100.00 worth of that bond. So why pay more or less?

In a word: YIELD. Yield is the rate of return paid on that bond over time. There are multiple different types of bonds, and each bond has a certain yield that it pays. You will sometimes hear us refer to yield as "coupon" or "issue." As you might guess, the higher the yield, the more the buyer will make over time, so the more the buyer is willing to pay. For instance, if an MBS with a 3.0% yield costs $104.50, the investor pays $104.50 for the ability to collect 3.0% interest on $100.00. Conversely, yields that are low enough may have prices under Par (100.00), meaning that investors could buy $100.00 worth of MBS at a discount. Bottom line, the higher the coupon of MBS, the higher the price will generally be.

For this same reason, when considering only one coupon (you might find it easier to think of it as "if the coupon stays the same") and the price is going higher, then the yield for the investor goes lower (because they're paying a higher price for the same coupon yield). This is what we mean when we say "as price goes up, yields go down," which is a different concept that "higher yielding coupons fetch higher prices." This can be a bit of paradox for some, but if it doesn't make sense at first, try to separate the two different approaches mentioned above:

1. In this case, we're looking at and/or considering the price/yield relationship of numerous MBS coupons, at one moment in time, and noticing that the higher the coupon, the higher the price.

2. In this case, we're looking at one specific MBS coupon. The coupon doesn't change, but the price does. As the price moves higher and lower over time we're noticing that investors are paying more or less for the same coupon yield. Thus if prices for a particular coupon are moving higher, yields are moving lower.

Keep in mind that the COUPON YIELD of a particular MBS only determines the rate of return of whatever principal amount remains in the MBS pool purchased by the investor. Because the duration of a mortgage can vary (borrowers can sell, refinance, foreclose, etc..) the ACTUAL yield that an investor receives will depend on how quickly the loans in their MBS pools are retired. Suppose you paid $104.00 for the right to collect interest on a $100.00 loan. If the borrower pays you back before their first interest payment, now you've earned $100.00 for your $104.00 investment!!! Not profitable! You're realizing a MUCH lower yield than another investor whose borrowers keep their loan for several years.

This is the "Prepayment Risk" that investors seek to avoid and it's the reason for the various "early pay-off" penalties charged to originators if loans are retired or refinanced within a certain time frame.So MBS's are bonds! Where do they come from?

Grossly oversimplified and leaving out numerous items that are not germane to rate analysis, MBS are the bonds that mortgage loans are turned into when they are bought or sold. That's a tough one to grasp your first time around. I know it was for me.

Basically, Big Bank will write a check for your mortgage, say it's $100,000. Big Bank A then has a promissory note saying that you will pay them a certain interest rate over time (sound familiar?). But Big Bank A needs some more money to lend other people... Where to get it? I know! They can sell your mortgage note to someone else in the form of a bond! Hopefully, that investor is willing to pay something like $102,000 for the right to collect interest on your $100,000 loan. Big Bank A just made $2000, and the investor has something that will hopefully pay them interest over time. Remember price vs. yield? The higher your interest rate, the more the investor would be willing to pay Big Bank A. That's YSP Baby! And if the investor is only going to pay $97,000 for the loan, that means Big Bank has to pay them a discount to buy it, which was probably passed on to you on line 802 of the GFE! Now YSP starts to become clear I hope!

But there's a big problem! The investor doesn't want all of their risk riding on one loan, so we have to find a way to spread out the risk. Because even if you only have a 3% chance of defaulting, in the event that you do, the investor would lose his hat. So to spread out the risk, Big Bank A combines your loan with 10's to hundreds of other similar loans with similar rates and similar credit quality.

Then either by selling them directly to Fannie Mae and Freddie Mac or by utilizing Fannie and Freddies Protocols and doing it themselves, Big Bank A accomplished what is known as SECURITIZATION. Now the "pool" (collective of all the bundled loans which will now be in the millions of dollars) can be broken up into bond-sized chunks. Now instead of buying one loan for $100,000 dollars (give or take), and investor can buy a portion of 10's to hundred's of loans for the same amount of money, with the same rate of return, with the same risk of default. BUT NOW, if you apply the 3% rate of default, the investor only loses 3%! Brilliant! And it's a concept that has allowed a significantly larger amount of money to be available for home loans than ever before.We just said that investors are paying 102% of the face value of a bond in certain cases right? So what happens if they are not interested at that price any more? No more liquidity for the mortgage market. So how do you combat this? In a nutshell, the market forces of supply and demand take care of it. If demand for a bond is low when the price is 102.00, then the sellers of the bonds may lower the price to 101.50 to ENTICE investors to start buying again. And what did we already say would happen to the YIELD when the price got lower for a particular issue? It goes UP because the same money the investor was going to spend, now buys more shares. So their rate of return per dollar spent (yield) goes up.

Those pricing adjustments from 102.00 to 101.50 should look familiar. They move in exactly the same proportion to YSP. Although Big Bank A has to pull profit off that for themselves, THE PRICES OF MBS ALWAYS MOVE IN DIRECT PROPORTION TO THE PRICES (YSP IF POSITIVE, DISCOUNT IF NEGATIVE) OF THE MORTGAGES FROM WHICH THEY ARE DERIVED.

That is why we want to follow MBS instead of any other treasury or index in order to gauge the direction of the market. If investors are wanting to buy more MBS, then the prices are going to go up (Price vs. Demand function). Higher prices mean that Big Bank A makes more on a given coupon, which means they can originate a loan for your clients with either a slightly lower interest rate or a slightly higher YSP. Your choice!

So that is the theme of any mortgage market analysis. We want to assess the movements of MBS prices (which change by the second), in conjunction with the macroeconomic climate, in order to determine which way they might be headed and what future events can have an impact.

For instance, inflation data being negative hurts bonds because bonds return a fixed income. So if inflation has devalued the dollar over time, the bond is not really worth as much as when it first was purchased. So high inflation makes investors seek higher yields in order to get on that boat. Another popular correlation is that a booming economy draws money out of bonds and into more rapidly appreciating stocks. This causes bond owners to lower the price to entice buyers which raises mortgage rates. That is why, if you look at a historical chart of recessions and interest rates, you will almost always see recessions coincide with low rates.

Beyond that, there's only a little more you need to know when reading my analysis.

First of all, there are several coupon rates ranging from 4.5%-7.5%. Right now, we primarily track the 5.5% coupon and the 6.0% coupon as most of the trades are taking place in that range, giving us a higher sample size and thus more reliable data. We will always report on the bond coupons that are closest to PAR for this reason (par meaning a cost of 100.00).

Bonds move in 32nds. So 101-32 would actually be 102-00. And 101-16 would actually be 101.50 in decimal form. So when you see prices improve by 16/32nds, that means that at some point in the future, lenders have the ability to improve the YSP on rate sheets by .500. NOW, in this day and age, lenders are not quick to pass on a price improvement to its full effect. They want to see the market hold its gains for a bit. However, if the market worsens, they will hedge their positions by taking even more away from you than they have lost on price. This is just smart business, and it's a balancing act between lenders to see who reprices and by how much. I will often times refer to 32nds as TICKS. So if I say "we're down 6 ticks on the 5.5," that would mean that the 5.5% coupon MBS has declined in price by 6/32nds from yesterday's close. Lot less typing my way!

Tight or Wide. Bond investors have a choice between MBS and other types of bonds. The benchmark competitor is the US 10 year treasury. MBS price relative to treasury price is important because even if mortgage prices go up on the day, if treasury prices go up a whole lot more, the MBS will still be the better investment all other things being equal. Because there is a significantly higher amount of risk in MBS than in treasuries, the MBS prices will ALWAYS be lower than treasury prices for a similar coupon amount. So when prices rise on MBS and "close the gap" on treasuries, we say "MBS are trading tighter." You might also hear "tighter to the curve," meaning the yield curve. Wide is simply the opposite.

Graphs. Hopefully the graphs I've been posting make much more sense now. They are simply tracking the curve of the price of a particular coupon throughout the day. As the curve gets higher, rates have the potential to go lower and vice versa. There is a school of thought known as "technical analysis," which some think is crazy voodoo, while others think it is gospel. Basically, technical analysis throws all economical analysis out the window and simply focuses on the numbers, what they have done in the past, their propensity to "obey" certain trends, their resistance to certain price floors or ceilings, etc... I am a fence-sitter when it comes to Technicals. I will comment on them, but always keep in mind that technical analysis must be considered in conjunction with the rapidly changing economic climate.

So for instance, if I say "there is a price floor today that has been established at 99-16," that means that bond prices have resisted going below the horizontal line on the graph at the 99-16 mark. If bonds then were to break through that floor and go lower, it could indicate a potential increase in pressure to sell, which would hurt rates. Hope that makes sense.We just said that investors are paying 102% of the face value of a bond in certain cases right? So what happens if they are not interested at that price any more? No more liquidity for the mortgage market. So how do you combat this? In a nutshell, the market forces of supply and demand take care of it. If demand for a bond is low when the price is 102.00, then the sellers of the bonds may lower the price to 101.50 to ENTICE investors to start buying again. And what did we already say would happen to the YIELD when the price got lower for a particular issue? It goes UP because the same money the investor was going to spend, now buys more shares. So their rate of return per dollar spent (yield) goes up.

Those pricing adjustments from 102.00 to 101.50 should look familiar. They move in exactly the same proportion to YSP. Although Big Bank A has to pull profit off that for themselves, THE PRICES OF MBS ALWAYS MOVE IN DIRECT PROPORTION TO THE PRICES (YSP IF POSITIVE, DISCOUNT IF NEGATIVE) OF THE MORTGAGES FROM WHICH THEY ARE DERIVED.

That is why we want to follow MBS instead of any other treasury or index in order to gauge the direction of the market. If investors are wanting to buy more MBS, then the prices are going to go up (Price vs. Demand function). Higher prices mean that Big Bank A makes more on a given coupon, which means they can originate a loan for your clients with either a slightly lower interest rate or a slightly higher YSP. Your choice!

So that is the theme of any mortgage market analysis. We want to assess the movements of MBS prices (which change by the second), in conjunction with the macroeconomic climate, in order to determine which way they might be headed and what future events can have an impact.

For instance, inflation data being negative hurts bonds because bonds return a fixed income. So if inflation has devalued the dollar over time, the bond is not really worth as much as when it first was purchased. So high inflation makes investors seek higher yields in order to get on that boat. Another popular correlation is that a booming economy draws money out of bonds and into more rapidly appreciating stocks. This causes bond owners to lower the price to entice buyers which raises mortgage rates. That is why, if you look at a historical chart of recessions and interest rates, you will almost always see recessions coincide with low rates.

Beyond that, there's only a little more you need to know when reading my analysis.

First of all, there are several coupon rates ranging from 4.5%-7.5%. Right now, we primarily track the 5.5% coupon and the 6.0% coupon as most of the trades are taking place in that range, giving us a higher sample size and thus more reliable data. We will always report on the bond coupons that are closest to PAR for this reason (par meaning a cost of 100.00).

Bonds move in 32nds. So 101-32 would actually be 102-00. And 101-16 would actually be 101.50 in decimal form. So when you see prices improve by 16/32nds, that means that at some point in the future, lenders have the ability to improve the YSP on rate sheets by .500. NOW, in this day and age, lenders are not quick to pass on a price improvement to its full effect. They want to see the market hold its gains for a bit. However, if the market worsens, they will hedge their positions by taking even more away from you than they have lost on price. This is just smart business, and it's a balancing act between lenders to see who reprices and by how much. I will often times refer to 32nds as TICKS. So if I say "we're down 6 ticks on the 5.5," that would mean that the 5.5% coupon MBS has declined in price by 6/32nds from yesterday's close. Lot less typing my way!

Tight or Wide. Bond investors have a choice between MBS and other types of bonds. The benchmark competitor is the US 10 year treasury. MBS price relative to treasury price is important because even if mortgage prices go up on the day, if treasury prices go up a whole lot more, the MBS will still be the better investment all other things being equal. Because there is a significantly higher amount of risk in MBS than in treasuries, the MBS prices will ALWAYS be lower than treasury prices for a similar coupon amount. So when prices rise on MBS and "close the gap" on treasuries, we say "MBS are trading tighter." You might also hear "tighter to the curve," meaning the yield curve. Wide is simply the opposite.

Graphs. Hopefully the graphs I've been posting make much more sense now. They are simply tracking the curve of the price of a particular coupon throughout the day. As the curve gets higher, rates have the potential to go lower and vice versa. There is a school of thought known as "technical analysis," which some think is crazy voodoo, while others think it is gospel. Basically, technical analysis throws all economical analysis out the window and simply focuses on the numbers, what they have done in the past, their propensity to "obey" certain trends, their resistance to certain price floors or ceilings, etc... I am a fence-sitter when it comes to Technicals. I will comment on them, but always keep in mind that technical analysis must be considered in conjunction with the rapidly changing economic climate.

So for instance, if I say "there is a price floor today that has been established at 99-16," that means that bond prices have resisted going below the horizontal line on the graph at the 99-16 mark. If bonds then were to break through that floor and go lower, it could indicate a potential increase in pressure to sell, which would hurt rates. Hope that makes sense.

First, note that "exiting QE in a timely fashion" would hardly solve the problem. It might, of course, save the dollar from destruction -- as perhaps Volcker did. That would be good. But there are other concerns.

The Fed's manipulations of interest and money do their grievous damage during the expansion phase. The theory explaining this is very solid, in my opinion, and all we have to do is look at the recent/boom bust cycles for experiential confirmation. It doesn't take any advanced math or statistical correlations.

Your proposition (that we should be able to get rich if we guess correctly how things are going to break) demonstrates what has become of our investment markets. That's exactly how every professional investor is thinking these days, and it means that capitalism no longer exists in America. The only way to truly benefit, in my opinion, is to be part of the system ... part of the problem. The chairman of Goldman Sachs does amass a great fortune, and he can make sure he keeps it by simply putting a little gold bullion into safe keeping in several of the safer jurisdictions around the world.

The rest of us, I think, can aspire to survival, but I doubt we can be better off after the next crisis. Note Volcker's last paragraph:

"The erosion of confidence and trust in the financial world, in the financial authorities that oversee it, and in government generally is palpable. That can’t be healthy for markets or for the regulatory community. It surely can’t be healthy for the world’s greatest democracy, now challenged in its role of political and economic leadership…”

There is a line of thought that makes more and more sense to me. That is, the next crisis will involve the loss of confidence in central banking. The reasons for that loss and the further consequences are impossible to predict in particulars. But the results could leave us all in a rather bad way. Here, below, is part of a Pater Tenebrarum post on the subject -- focussed mainly on Japan's situation. But it's all the same.

Tom

Peter Atwater on Kuroda – The Coming Loss of Faith in Central Banks

In the context of the above and as an addendum to what we have previously written about Japan, we want to direct readers to an excellent article by Peter Atwater on the Kuroda gambit. We wish we had thought of the title ourselves: “What If Abenomics Is to Policy-Making What Subprime Lending Was to Housing?”

Atwater discusses a topic that we have frequently mentioned in these pages and the importance of which we believe cannot be stressed enough. Namely the fact that faith in the omnipotence of central banks is eventually going to erode and when it goes, we will see market upheaval like never before. Our own theory on this point is that both the 2008 crisis and the subsequent euro area debt crisis have shown that central banks were really the last bastion able to restore investor confidence. It follows from this that in the event that confidence in central banks wanes, the mother of all financial accidents is likely to follow.

Here are a few pertinent excerpts from Atwater's article, which is well worth reading in its entirety:

“To succeed, Mr. Kuroda would need complete capitulation. To whip deflation, Mr. Kuroda required an immediate and profound shift in the market’s belief system. He had to reset expectations and convince businesses, consumers, and other policymakers that “everything from wages and corporate profits to the price of stocks” would be on the rise. There was no room for even the slightest hesitation or doubt; no time for questionable “green shoots.” Everyone had to immediately buy into the certainty of a mature bamboo forest watered to perfection by central bank liquidity.

For investors already primed by the Fed’s Buzz Lightyear and the ECB’s “whatever it takes” extreme monetary policy actions, the message was clear: Go long the Nikkei and Japanese Government Bond and short the yen, and do it with the maximum amount of leverage as possible. This wasn’t just a TINA (“Theirs Is No Alternative”) trade, this was the TINA trade, where it paid to immediately capitulate and in size. Investors met Mr. Kuroda's craziness and immediately raised him.

[…]

What fascinates me most, though, about the situation in Japan, was not the action of the BOJ, but the behavior of investors: They completely capitulated. Having been well-primed by prior experience, they didn’t wait to be painted into a corner by policymakers; they eagerly took out their own brushes and painted themselves into a corner. TINA became TOA – “The Only Alternative.”

While on the surface this would appear to be a major victory for central bankers, I am afraid that Mr. Kuroda’s success may represent a peak in investor confidence in central bank policymakers. After capitulation – particularly saturating capitulation in which everyone is all in – what does a central banker do for an encore?

[…]

I would pay extremely close attention to what now happens in Japan. Bubble bursts have a LIFO (last in / first out) quality to them. The most extreme case, which occurs at the very peak of confidence, always turns first. Given the yield move in JGBs over the past six weeks and last week’s move in the Nikkei, it feels like a major turn is now afoot. While this doesn’t prevent other global markets from going on to new highs, I would be very careful to assume that what has taken place in Japan this week is at all contained. Like subprime mortgages in 2007, “contained” is more likely to mean "just the beginning."

Even more, when it comes to confidence in global central banking, investors can’t be half-pregnant. One either believes or doesn’t. The decision is binary. One is either painted into a corner or isn’t. Admittedly, there is an enormous irony for policymakers in all of this. Like every other market Big Truth, when everyone is certain it is true, the top is in. For central bankers, I am afraid that once everyone believes in their omnipotence, it is lost.”

(emphasis added)

Obviously we believe Mr. Atwater is on to something here. It may still be too early to sound the death-knell on the Kuroda reflation experiment, but there is a reason why we have recently spilled so much ink on Japan and tried to familiarize readers with every possible angle of the Kuroda gambit. We always stress that one must keep an eye on the JGB market, as that is the market in which control will most likely be lost. However, there are other possibilities as well, and it is even likely that eventually, several markets are going to haywire at the same time. Anyway, Atwater's point that “once everybody believes in the omnipotence of central banks, it is lost”, strikes us as extremely important.

Now think about what we noted about the Fed and its 'QE' program above: the Fed is now 'groping in the dark' – similar to a socialist central planning organization that can no longer observe the outside market signals that are most relevant to its plans. We conclude that the times are sooner or later going to get very 'interesting', in the Chinese curse sense.

Is Krugman right? This is not my field. I don't know enough to agree or disagree. I wonder if anyone on the board or if Scott Grannis would care to comment. An article from a recent Economist edition:

*****The austerity debate

Dismal pugilists

Mudslinging between economists is a distraction from the real issues Jun 1st 2013 |From the print edition

THE brawl featuring two economists, Carmen Reinhart and Kenneth Rogoff, and a Keynesian militia led by Paul Krugman, a Nobel prize winner, refuses to die down. It makes entertaining academic theatre. Sadly, it also distracts from an emerging consensus on how countries should best cope with debt.

In 2010 Ms Reinhart and Mr Rogoff initiated an influential line of research with a paper that purported to show that growth slowed dramatically when public borrowing rose above 90% of GDP. The work quickly became beloved of austerity-minded politicians in Europe and America. Then in April three economists from the University of Massachusetts, Amherst, said that unorthodox statistical choices and a spreadsheet blunder had led Ms Reinhart and Mr Rogoff to exaggerate the drop-off in growth at high debt levels.

Keynesian academics pounced, declaring the intellectual foundation of austerity destroyed. The most damning salvos came from Mr Krugman in an essay saying the 2010 paper had “more immediate influence on public debate than any previous paper in the history of economics”, yet its conclusion and methodology should have been suspect from the start. Ms Reinhart and Mr Rogoff struck back on May 25th in an open letter to Mr Krugman, decrying his “uncivil behaviour” and his own misstatement (Mr Krugman accused the authors of failing to make public their data; they had. It was their spreadsheet calculations that were not publicly available).

The heat has risen, but the meat of the debate has changed little; if anything, differences may be narrowing. Ms Reinhart and Mr Rogoff now emphasise their less sexy results, that as debt rises growth merely slows, rather than collapses, a point on which many agree. In their letter to Mr Krugman they acknowledge that research is mixed on whether higher debt leads to slow growth or vice versa, long the key criticism of their work. They continue to argue for cautious, proactive debt-reduction. But they say they favour writing down bank debt, slightly higher inflation and “financial repression” (imposing lower real returns on creditors) over immediate austerity.

Those policies are much more to Mr Krugman’s liking. Yet their letter pointedly does not aim to mend fences (it is doubtful Mr Krugman would be interested). And the rhetorical battle obscures important areas of agreement. Austerity that undermines growth does not help; writing down private debt and boosting growth through monetary stimulus and supply-side reform do. That would be a useful message for politicians, but they may struggle to hear it above the din.****

"I share all of these concerns about the Feds ability to exit QE in a timely fashion. So what should an investor do when confronted with this risk? That is arguably a more important question than whether the fed should be reformed." - Scott G.

An investor can be in non-dollar assets when the dollar collapses, assuming full knowledge. I think the DOW and the other indices reflect that as people are really buying market share in these industries rather than risking investment in a a start-up company or holding anything dollar-based. There are other defensive schemes to be sure, gold, commodities, real estate I suppose. I own low end housing that sadly seems to be coming back into fashion in our expanding, low end economy. But I don't want to be a rich guy in a collapsed economy. I'd rather be an ordinary participant in a healthy economy.

I agree fully with this approach. Based upon what I have seen andreviewed, at least 50% will default within two years, no matter whattype of modification is given. The people simply do not have the incometo support a mortgage, pay other debt, and meet living expenses.

By doing more short sales, it begins to clear out the Private MBSbacklog of troubled loans. It gets people out of the loans, so they can"move on" with their lives, even at a reduced "living standard", and itends the "free ride" that so many "homeowners" are getting for up tothree years.

If government would get out of the way and let "natural actions" clearthe market, housing recovery would be shortened considerably.

Since the 2008 financial crisis, servicers dealing with loans tied toresidential mortgage-backed securities have changed with the times moving from a sharp focus on loan modifications to short sales.

A new report from *Fitch Ratings* claims over the last few years, loanmodifications have slowed as the preferred choice for servicers dealingwith distressed loans.

Instead, short sales are ‘in’ as the preferred strategy among U.S. RMBSservicers, says Fitch managing director Diane Pendley.

Short sales for non-agency loans peaked at 51% in November 2012 whenanalyzing the disposition methods of bank servicers, Pendley said. Thatis up 20% from two years earlier.

"Short sales among non-bank servicers have also increased, peaking at16% in October 2012 from 11% two years prior," she added.

Loan modifications also are down as mortgage delinquencies drop, Pendleysaid. Yet, they also are falling, with short sales now a more populardisposition choice, especially when dealing with prime borrowers.

A decline in loan mods also may be a sign that some borrowers no longerqualify for modifications after receiving mods in the past. Failing toqualify for another modification means a short-sale transaction becomesa more likely outcome.

Short sales currently make up 64% of liquidations among prime borrowers,the ratings giant said.

In the Alt-A segment, short sales represent 53% of liquidations, whileshort sales make up 42% of subprime resolutions, based on Fitch data.

"The increased use of short sales may also be the result of servicer'sefforts to reduce the impact of foreclosure on borrowers who havere-defaulted loan modifications," Pendley writes. "Currently, themodification re-defaults after 24 months are 24% for prime, 36% forAlt-A, and 43% for subprime."

What’s interesting to Pendley is how much the market is now driven bynon-bank servicing firms.

But non-bank servicers are adding staff as their portfolios increase.Pendley says these firms are now pulling in more of the banks businesssince they are able to aggressively use loan mod strategies whileproducing shorter resolution timelines.

I have been missing out on things here. Once I get wrapped up on some work I have been doing, I might have the time to play again.

What CD posted is part of an ongoing argument that Scott, Tom and I have been having regarding the Fed. The arguments are based upon whether the Fed is creating money in the traditional sense or not, and whether the Fed is manipulating money supply in a manner that does not effect M2. Then, it evolves to whether the "Housing Recovery" is being caused by the Fed easy money policies, whether it is sustainable, or even if it is a recovery at all. Finally, it goes to whether the stock market and bond market are up because of Fed policies and easy money or not.

Of course, I take the opposite position of Scott in every way imaginable. (Note: I will admit finally that the Fed is not "creating money" by the technical definition, but I will argue all day long that they are manipulating money supply.)

It has been a very frustrated and heated argument at times, and often extremely confusing. But that can be the fun of it.

I had to sign up for this site to see Scott Grannis's piece but the piece is well worth it and the site appears to be worthy as well. I've already gotten some mini-reports on CREE that were of interest to me

Whatever the housing activity -- strong or weak, consistent or inconsistent -- it's all happening within the context of massive market interventions. Just the interest rate manipulations alone ensure that investments in housing are severely distorted relative to what would be happening in a free market environment. How anybody can get excited about growing action in housing is beyond me. These are no doubt the same people who thought the housing mania was a time of great economic growth.

As for Wall Street's move into rental housing ... that's just one more example of how loose money policies lead directly and indirectly toward capital misallocations -- while putting billions of dollars into the pockets of the great Wall Street financial manipulators. Wall Street is making no meaningful contribution to the economy with this new misuse of other peoples' money.

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Scott's answer:

You assume things that are not necessarily true.

If monetary policy were massively loose, the dollar would be tanking, inflation would be soaring, and interest rates would be on the moon. But they are not.

If the Fed were manipulating interest rates, they would be falling, not rising. 10-yr Treasury yields have risen for the duration of every QE episode to date. They have only fallen when there was no QE.

Housing starts absolutely collapsed beginning in 2006, and home prices fell by 35-40%. How much more devastation would you have expected from a supposedly free market?

Wall Street is playing with its own and investors' money these days. That's a free market. Whether they are right or not is anybody's guess. If they have manipulated the housing market too high, they will get crushed, because it's not easy to sell sell thousands and thousands of houses quickly or cheaply. Nobody is subsidizing this foray into institutional ownership of the housing stock. It will be very interesting to see how it plays out.

Scott's answer: ... "Housing starts absolutely collapsed beginning in 2006, and home prices fell by 35-40%. How much more devastation would you have expected from a supposedly free market?"

It was not a free market or neutral Fed that led to the over-supply of housing in 2006. It was a government distorted market and a Fed flood of 'liquidity' that set the table for the disaster that ensued. It is not devastation to have assets consistently valued at undistorted market value.

SG: "Wall Street is playing with its own and investors' money these days. That's a free market. Whether they are right or not is anybody's guess. If they have manipulated the housing market too high, they will get crushed, because it's not easy to sell sell thousands and thousands of houses quickly or cheaply. Nobody is subsidizing this foray into institutional ownership of the housing stock."

1) The Fed is distorting the free market choice between equities and interest bearing investments, which is bidding up the share price of existing companies at the detriment of other choices, including moving people from safety to risk.

2) The Fed is enabling and subsiding the irresponsible fiscal policies and the big government scale in Washington. The Fed issues bonds to cover excess spending without having to find willing, free market buyers for all the bonds. Without monetary cover from the Federal Reserve, the excesses of Washington spending on this scale would not be happening! 6 of the 10 'richest counties in America are in the DC area. What is the industry driving that and who is underwriting it?

3) The large players operate in an environment where both the institutions and the individuals running them receive the benefits on the upside but have faced little or no consequence for their failures. (cf. Citigroup, AIG, Goldman Sachs, General Motors, JP Morgan, Wells Fargo, Bank of America, Fannie Mae, Freddie Mac, Morgan Stanley, US Bank... http://projects.propublica.org/bailout/list) Hardly a free market. They will not be bailed out again? Why would they think that??

The main comment of Scott was "Housing recovery continues 3 months' worth of data released today show that while the housing market took a pause in the Fall, activity continues to push higher."

Now, my comments:

Scott, you friggin drive me nuts with this very "basic" and "superficial" analysis, time and again. You look at the charts and the data releases with the same overview, and make conclusions based upon that without looking at the underlying data. You and Bill McBride and others do the same thing every time.

How do you propose to argue these points?• Existing Home Sales are now in a falling pattern.• Home value appreciation has now slowed to more normal rates, but are expected to begin decreasing.• Pending sales are declining for 4 straight months now. Since at least 40% will fall through, this will affect Existing Home Sales negatively in the months to come.• New home sales were falling from Jun 2013 on until Oct. Oct will be revised downward in the Nov report• Long term data points still show that Home Sales remain in the lowest percentile of home sales seen since 1963.• New Starts increases are primarily in rental properties• Non Seasonal Adjustments show declining SFR starts(This is all you get when the Fed and the government have spent all the time and money and QE trying to prop up the market?)Next, what about the new regulations taking affect Jan 2014? These regulations are creating greater lender liability and uncertainty, lending to more lending problems. Also:• QM and Non QM loan standards are still being implemented. Lenders are going to be very restrictive in lending due to the new requirements.• Investors are leaving the market now, so this is less of a source for purchases• 1st Time Buyers are greatly reduced. They helped propel the market, but now are being priced out of the market.• Move up buyers still don't exist in great numbers, though they are the ones who really drive the market.• Housing affordability is once again at the highest levels since 2002. People are being priced out of the market, even move up buyers• Increasing Interest Rates. No it is not because the Market has improved and demand is driving them up. If fact, demand is down based upon the refinance market having dropped 60% over the last five months thanks to the higher rates. Refinances are much more important that Purchases and in greater quantity by several times. Refinances drop and there is less demand.• 25 to 34 age cohort cannot buy homes due to student loan and other debt, yet they are where the purchases need to occur for first time buyers. 35-44 cohort has similar issuesAnd don't forget the foreclosure problems. • There are over 5m loans still delinquent or in default. 90% will end up being foreclosed upon.• HAMP modifications have 939k loans currently in the program. 30% default within the first 18 months. By 36 months, it is about 45%. These defaults occur BEFORE the interest rates begin to increase in year 6.• New foreclosures to occur as income decreases continue and the adverse affects of programs like Obamacare on income.You cannot simply say that Housing is improving looking at a couple of data sets. It does not work that way. You have to consider all the factors involved and how they will affect housing in the near term and the far term.The Key Risk Indicators for housing (ourselves and lenders) are all negative except for the Homebuilder's Confidence Index and Housing Starts. The Indicators are looking forward from 3 months to 1 year only.Of course, Mark Hanson or I do not have as much knowledge and experience as you have in this. Mark has only lived this 24/7 for over 20 years. I have only done the same for 16 years. I guess we need much more knowledge and experience to reach your level.=========================================================================

In my neck of the woods in Greensboro NC, there seems to be an upsurge in both single and multifamily construction. Lots of land getting cleared. Somebody around here must be lending.

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There are pockets of good activity in housing across the country, but it is not consistent everywhere. The South has been particularly strong, more than everywhere else, but it is seeing signs of dropping activity.The West, Arizona, CA and NV, are now severely dropping in activity.

The activity that occurred in construction has been dismal when you look at the long term yearly stats since 1963. In fact it is pathetic. Remove construction activity from "destroyed" homes in weather type events, and Single Family home construction is down. Multi Units is up only because there is a large "incoming" segment of the population which will only rent for a decade or more.

Housing is not just looking at a few charts and saying that everything is fine. It is getting into the weeds, sorting out the key data, and then taking into account not just current trends, but the new regulations coming into play, and then the demographic data that will be relevant over the next few years. When you do that, you get a completely different perspective of what is going on, and it is not pretty.===================================

We can see quite clearly, Scott, that the federal government (and the Fed) as massively intervening in our market system. How can you think these actions have no impact on market results?

The Fed has held the short rate at zero for years and promises to keep it there for an "extended" period, the Fed continues to buy government and mortgage-backed debt to the tune of nearly a trillion dollars per year, the Federal Government has nationalized the mortgage industry, the government continues to run deficits that have improved only in relationship to unthinkable deficits from a few years ago. And the government continues to try and "manage" the housing industry and the ongoing mortgage delinquency problem with complex schemes.

Money supply hasn't grown as fast as Fed reserves, of course, but the rate has still been substantial -- 10% per year at times -- and is still running at over 6% for M2.

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For what it is worth, the notable Jim Grant seems to agree that the Fed's interventions have an impact, an adverse impact. The following comments come via Agora's "5 Minute Forecast" email.

Tom

"If you ask economists, they will tell you that price controls are a very bad idea," says Jim Grant, proprietor of Grant's Interest Rate Observer. "But that's exactly what these mandarins at the Fed are doing," Grant says.That is, the Fed is manipulating the most important prices of all -- interest rates. Only last week, the Fed declared the fed funds rate would remain near zero "well past" the time the unemployment rate falls to 6.5%, from its current 7.0%."We are embarked on a unique experiment in monetary manipulation," he tells the German business weekly Finanz und Wirtschaft. "That kind of central banking might be more accurately called central planning."The result is a profound drag on progress. "Interest rates are so low that companies, even in a very bad way, can survive," Grant says by way of example. "That reduces in an unintended fashion the dynamism of our economy."In a dynamic society, entrepreneurs start things and other entrepreneurs finish them or bankers finish them for the entrepreneurs because the entrepreneurs have failed. Without failure, there really can't be any success. Otherwise, you have a futile system of permanent state-sponsored enterprises."

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Scott Grannis answers:

I would not argue that the Fed is not fixing the price of short-term money. Of course they are. But I would argue that the evidence suggests that they have apparently managed to fix the price of money at a level that has not resulted in any significant distortions. (The Fed probably contributed to the housing bubble, but most of the bubble was caused by government meddling in the mortgage and housing market.)

The Fed has been fixing the price of money for over 25 years (prior to that Volcker was targeting the money supply), and by and large it would appear that they haven't made a serious mistake, because inflation over the past 25 years has averaged about 2.7% per year. Arguably the Fed should on average have kept the fed funds target rate a little bit higher, in order to have delivered slightly lower inflation, but in the great scheme of things this is a pretty remarkable achievement.

The problem with the Fed for the past quarter century is not that they have been fixing the price of money at an arbitrary level, but that we never know until well after the fact if they are fixing the price too high, too low, or just right. They could have been making a mistake. They could be making a mistake today (and I think they probably are), but we can't know until more time passes.

Regardless, I don't think it is fair to say that the Fed today is making a big mistake just because they are keeping the funds rate near zero. Perhaps they are, but perhaps they aren't. They promise to keep it low for a long time, but that's not a promise they have to keep.

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Well, I think it down right crazy to think that ANY manipulation of this sort can fail to have adverse effects. The Fed governors are hardly omniscient. The only way to find out where market prices would be is to let the market set prices! It's a remarkable "achievement" that the Fed didn't create higher inflation?? If the Fed's job is to set the same rate (or as close as possible) as would be set on a free market, why does this entity exist at all?

Changes in consumer price levels are the least significant problem associated with monetary manipulation, as I have said often in the past. It is the relative price changes that do the damage and cause market distortions. And the Fed's manipulations have caused a myriad of distortions and repeated booms and busts. During the last ten years or so they have apparently seen fit to direct a huge additional part of national income toward bankers and Wall Street mavens, taking it directly out of the pockets of savers and "main street" economic players.

As you say, we will eventually see where the problems show up and in what ways they reveal themselves. I think you will be proven totally wrong about this, just as you were wrong about the housing boom. Our current economy has so many market distortions at work that the Fed finds it impossible to stop its monetary machinations without precipitating another crisis. As Grant said above, we should call this brand of central banking "central planning." Hail to the monetary Politburo.